How Marriage, Divorce, and Death Can Affect a 1031 Exchange

Marriage, divorce, and death are among life's most significant events. When they occur during a 1031 exchange, they can introduce complications that affect whether the exchange qualifies for tax deferral.

Fortunately, with careful planning, many of these challenges can be navigated while preserving the benefits of a 1031 exchange.

At the center of these situations is the "same taxpayer rule": generally, the taxpayer who sells the relinquished property must be the same taxpayer who acquires the replacement property. While this may sound straightforward, changes in marital status, property ownership, or an investor's circumstances can make compliance more complicated.

Here's how these life events can affect an exchange and what investors should consider.

Marriage and 1031 Exchanges

Many married couples own investment real estate together. When jointly owned property is sold as part of a 1031 exchange, both spouses generally must also be owners of the replacement property to satisfy the same taxpayer rule.

But what happens when one spouse purchased an investment property before marriage and now wants both spouses to own the replacement property?

Adding a spouse to the replacement property's title can create a same taxpayer issue, although the rules may differ in community property states.

Fortunately, careful tax planning may offer a solution.

Under Section 1041 of the Internal Revenue Code, transfers of property between spouses generally do not trigger recognition of gain or loss. In this situation, the original owner could transfer an interest in the property to their spouse so both names appear on the title before the exchange.

Timing, however, is important. While some tax professionals are comfortable with transfers immediately before or after an exchange, others recommend making ownership changes at least one to two years before or after completing a 1031 exchange. Investors should consult their tax advisors before making these changes.

When Financing Requires Both Spouses on the Title

Lender requirements can introduce additional complications.

For example, an investment property may be owned by one spouse, but the lender financing the replacement property may require both spouses to appear on the loan application and deed.

This creates a potential conflict with the same taxpayer rule, since the ownership of the relinquished and replacement properties would differ.

One potential solution is to purchase a replacement property with a higher value than the property being sold and allocate ownership interests accordingly. If the original owner's proportional interest in the replacement property equals their exchange value, the transaction may be structured to preserve compliance with the same taxpayer rule.

Example: Kelsey and Dave

Kelsey purchased an investment property before marrying Dave. She is now selling that property, which is debt-free, for $900,000. Together, they want to purchase a replacement property worth $1,000,000.

All exchange documents are prepared in Kelsey's name.

At the replacement closing, Kelsey acquires a 90% ownership interest, while Dave acquires the remaining 10%.

Kelsey's 90% interest represents $900,000 of the replacement property's value, matching the exchange value from her relinquished property. Under the structure described, Kelsey satisfies the same taxpayer requirement for her exchange.

This example illustrates how differing ownership interests may help accommodate a couple's goals while preserving the intended exchange treatment, subject to appropriate tax planning.

Divorce and 1031 Exchanges

Divorce can significantly complicate a planned or ongoing 1031 exchange, particularly when jointly owned investment property is involved.

Section 1041 generally permits certain property transfers between spouses or former spouses incident to divorce without recognizing gain or loss. This can provide flexibility when dividing investment real estate.

However, the timing of the exchange, divorce proceedings, and property transfers can be critical.

If a 1031 exchange is already underway or about to begin, completing the transaction before filing for divorce may simplify matters, depending on the circumstances.

When spouses own investment property as tenants-in-common, each generally holds a separate ownership interest. This may allow each spouse to complete an independent exchange or instead sell their interest and recognize the applicable tax.

Once divorce proceedings begin, restrictions on selling or acquiring property may apply under state law or court orders. In some situations, it may be preferable to complete the divorce and any required property transfers before starting the exchange.

Example: David and Ashley

As part of their divorce settlement, David agrees that Ashley will receive the 40 acres of highly appreciated land they purchased together.

Ashley wants to sell the land and complete a 1031 exchange into income-producing property to generate cash flow.

To preserve the intended tax-deferral benefits, Ashley should wait until the court issues the final divorce decree and David transfers his ownership interest to her before selling the property and beginning her exchange.

This allows Ashley to enter the exchange as the owner of the relinquished property and acquire the replacement property in the same capacity.

The key takeaway is that ownership changes and exchange timing should be coordinated carefully with the divorce settlement. Depending on the circumstances, completing an exchange before divorce proceedings or waiting until the required property transfers are finalized may help avoid complications.

Death During a 1031 Exchange

The death of an investor during a 1031 exchange presents another set of challenges, particularly when the relinquished property has already been sold but the replacement property has not yet been acquired.

If an investor dies after selling the relinquished property, the exchange generally must still be completed to preserve the intended tax-deferral benefits.

If the exchange is not completed, the sale may become taxable, with the resulting tax liability addressed through the decedent's final return or estate, depending on the circumstances.

Ordinarily, inherited property may receive a basis adjustment to fair market value at death. However, when the relinquished property was sold before the investor died, that property is no longer owned at death, and the usual basis adjustment does not apply to it in the same way.

This makes completing an exchange particularly important in certain estate situations.

When One Spouse Dies During an Exchange

If a married couple jointly owns the relinquished property and one spouse dies before the replacement property is acquired, the deceased spouse's estate may need to complete that portion of the transaction to preserve the full exchange benefits.

Example: Steve and Beth

Steve and Beth purchased land 40 years ago for $100,000. They later sell the property for $1,100,000 as part of a 1031 exchange.

Five days after closing, Steve dies.

The family promptly establishes the necessary legal authority under Steve's will. Their son, Christopher, acting as executor, signs on behalf of the estate to complete the exchange.

In this example, completing the exchange preserves tax deferral on Steve's 50% share of the $1,000,000 gain, or $500,000, while also preserving the exchange benefits for Beth.

The original example also illustrates a potential basis adjustment associated with Steve's death, increasing the combined basis from $100,000 to $600,000: $550,000 attributable to Steve's portion and $50,000 to Beth's original portion. The availability and calculation of such an adjustment depend on the applicable tax rules and ownership circumstances.

This example highlights the importance of promptly establishing estate authority and coordinating with tax and legal advisors when an exchanger dies during an active transaction.

Planning Ahead Makes the Difference

Marriage, divorce, and death can create unexpected complications for a 1031 exchange, but they do not necessarily prevent an investor from completing a successful transaction.

The key is understanding how changes in property ownership and taxpayer identity affect the exchange, and planning around those changes before they create problems.

If you're planning a 1031 exchange or are already in the middle of one of these situations, consult your tax and legal advisors early.

Have questions about your exchange? ADE's experienced exchange consultants can help you understand the exchange process and coordinate with your advisors to navigate more complex circumstances.

These examples are intended to illustrate general principles. Actual tax outcomes depend on the specific facts, circumstances, and structure of each transaction.